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Robert Stephens, CFA
Robert Stephens, CFA
Articles (396) 

Seth Klarman on Risk Versus Reward

Avoiding unnecessary losses could produce higher long-term returns

September 21, 2020

It is easy to overlook potential risks when managing your portfolio in the current bull market. Rising stock prices over the past few months could mean that some investors are more concerned with potential returns than the prospect of permanent losses.

However, in my opinion, managing risk should form a central part of any value investing strategy. Addressing it could lead to a more efficient allocation of your capital that produces higher long-term returns.

Baupost co-founder Seth Klarman (Trades, Portfolio) has always spent a large proportion of his time considering potential risks. His requirement for a margin of safety when investing in new stocks and a patient approach may be key reasons for his consistent outperformance of the stock market.

Seeking a wide margin of safety

The stock market has risen 50% since its March 2020 low. However, this does not mean that it will continue to make gains in future. Investor sentiment could change very quickly based on current political and economic risks.

Therefore, buying stocks that have wide margins of safety could be crucial. A margin of safety provides some protection against the potential for future market declines. It may also lead to higher returns over the long run, as it prompts investors to only purchase stocks trading at prices that are below their intrinsic values.

Klarman has always sought a margin of safety when buying stocks. As he once said, "It is precisely because we do not and cannot know all the risks of an investment that we strive to invest at a discount. The bargain element helps to provide a cushion for when things go wrong."

Waiting for the right opportunities

It may be difficult to find favorable risk/reward opportunities within your circle of competence in this bull market. Some sectors contain a large number of stocks that appear to be overvalued based on their future prospects. This may tempt some investors to buy stocks that ultimately deliver disappointing returns in an uncertain economic environment.

In my view, using a patient approach and waiting for better opportunities could be a better idea than investing when the risk of loss is high. Holding cash may mean accepting disappointing returns in the short run due to low interest rates. However, it may prove to be an efficient allocation of capital if it provides you with the chance to access more attractive valuations and lower risks in future.

As Klarman once said, "Most institutional investors feel compelled to swing at almost every pitch and forgo batting selectivity for frequency."

Investing during volatile periods

There is a significant difference between risk and volatility. Risk is the possibility of permanently losing money. Volatility is how significantly a stock changes price over the short run. Therefore, even periods of high volatility do not necessarily mean there is a heightened risk of permanent loss.

In my view, risk should be a primary concern for all investors. By analyzing a company prior to purchase, in terms of its financial position and competitive advantage, you can significantly reduce the potential for permanent loss.

However, volatility should not necessarily be avoided. It can provide buying opportunities for investors who have a long-term outlook. They may be able to capitalize on large swings in the stock market to purchase companies at low prices that are only available temporarily.

Klarman has used high market volatility in the past to buy quality stocks at low prices. As he once said, "Volatility is a welcome creator of opportunity."

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